Research
Taxing Online Sales: Key Features
of Reforming The Collection of
Online Sales Taxes
GORDON GRAY | JUNE 29, 2014
SALES TAXES AND THE INTERNET ECONOMY
As access to the Internet has increased, so has Internet-based commerce. Retailers, both large
and small, greatly expand their potential customer base and offer the opportunity for their
customers to effectively peruse their shelves from the comfort of home. Indeed online sales
have become an increasingly significant share of overall retail sales going from 5.71 percent of
the total $3.613 trillion of retail sales in 2003 to 8.86 percent of the total sales figure of $5.068
in 2013.[1]
As this feature of the modern retail economy has expanded, the challenge of collecting taxes
due on online interstate commercial activity has strained state revenue services. At present,
online retailers are not required to collect sales taxes on out-of-state sales. This does not
eliminate the tax liability on a given transaction, but rather poses a major challenge to the
collection of tax owed under state and local law. As internet commerce has expanded, the
revenue lost to state and local budgets through uncollected interstate retail sales (including
catalogue sales) amounted to $23.3 billion in 2012. This is a significant sum. By comparison,
across states, between FY 2008-2013, states closed a cumulative $527.7 billion budget gap,
primarily through program reductions.[2] Flagging revenue collections might also lead to
other tax increases that could prove more damaging to state economies. CURRENT LAW
The current status of online sales and use taxes can be traced to a 1992 Supreme Court
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decision, Quill Corp. v. North Carolina (Quill), which held that out-of-state retailers do not have
to collect sales taxes for states in which they do not have “nexus” (usually defined as a
physical presence within a state). Under Quill, Congress would have to pass legislation that
allows states to require retailers without a physical presence in a given state to collect sales
taxes from consumers in that state. The federal legislation suggested by the court would not
impose a new tax but would address the collection issue raised in Quill.
Some retailers already voluntarily collect sales taxes from out-of-state customers. Consumers
are supposed to pay use taxes for purchases from out-of-state vendors that do not voluntarily
collect sales taxes, but largely do not, which is the source of the lost revenue.
KEY DESIGN ISSUES IN ONLINE SALES TAX REFORM: DESTINATION VS.
ORIGIN SOURCING Destination sourcing
On May 6, 2013, the U.S. Senate passed the Marketplace Fairness Act (MFA), S. 743, by a vote of
69-27.[3] The MFA authorizes states that pursue certain reforms and simplification measures
to require out of state retailers to collect and remit the due sales tax. The MFA requires that
states provide the necessary software to calculate the due tax for the appropriate jurisdiction.
It also exempts retailers with less than $1 million in out-of-state sales.
Underpinning the MFA is the concept of destination sourcing, which places the tax burden on
the consumer – the “destination” of the sale. For example, a business based in Kentucky selling
a good to someone in Texas collect and remit the Texas sales tax. This is conceptually the most
appropriate approach to a consumption-based tax, as it identifies the tax burden on the
consumer and subjects that activity to the state tax laws in which that consumer lives. This
also avoids “taxation without representation” and more directly engages a taxpayer with the
budgetary environment and policies of their home state.
The downside is that under a destination-sourced regime, each subject business would
necessarily have to comply with sales tax requirements in each state and jurisdiction in which
it has customers. This has a burden associated with the scale and complexity of the various
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state taxes. Still, this should not be overstated, as efforts at simplification, and developments
in software could obviate much in the way of the administrative burden.
Origin sourcing
An alternative approach is to identify the tax burden with the physical location of the business
making the sale. For example, a business based in Kentucky selling a good to someone in
Texas collect and remit the Kentucky sales tax. This is a simpler approach insofar as it would
require each business to comply with only one sales tax regime—those in its state and local
jurisdiction. Origin sourcing is already used by Texas and Virginia to determine sales taxes for
cross-county transactions.
However, there are significant downsides to an origin approach as well. An origin-sourced tax
regime could have dramatic impacts on the structure of state budgets. First, it might induce a
“race to the bottom” by incentivizing retailers to avoid sales taxes by moving their operations
from high-tax states to those without sales taxes. According to some tax experts this could be
accomplished relatively simply and purely as a function of tax avoidance.[4] There is also
serious risk associated with how to define and enforce “origin” in a federal law that presents
further opportunities to game the system. Moreover, states would not receive the full revenue
of their sales taxes, leaving holes in their state budgets – either because only low-tax states’
amounts were collected or because pressures forced the state to reduce or eliminate its sales
tax. Either way, states would shift to a reliance on higher state and local income and property
taxes.
Finally, there are broader conceptual challenges to an origin-sourced system as well. States
would be able to tax residents of other states, meaning that those subject to a tax cannot elect
the leaders who set the tax (i.e., “taxation without representation”). Those same elected
leaders set the sales tax based both on the tax rate and the tax base, or taxability of particular
items (e.g. clothing, food, and pharmaceuticals). Taxability designations vary between
jurisdictions, just as rates vary, based on policy priorities set by the state and local
governments. An origin-sourced system would impose both new rates and new taxability
burdens on consumers who would not have recourse through the electoral process. AMERICANACTIONFORUM.ORG
A similar approach to a purely origin based tax would require the collection of taxes by seller, and according to the sales tax laws governing the location of the seller, which would then be
remitted to the location of the buyer. This approach, known as hybrid origin-sourcing, seeks to
address some of the flaws in origin sourcing, and to address some of the challenges of a
destination sourced tax regime, largely the administration burden of a seller complying with
multiple tax jurisdictions. In any new tax collection regime, particularly relative to one in
which owed taxes are simply not collected, there will be some additional burden. It is
therefore essential that they be mitigated, but mitigated consistent with optimal policy design.
A hybrid-origin system suffers from the same deficiencies as an origin-sourced approach
insofar as such an approach would retain the presumption that incidence of the tax is the
seller, rather than the purchaser. This retains the incentive to administratively locate the
nexus of the sale in a low or no-tax state and divorces the consumer from the polity imposing
the taxes, resulting in taxation without representation.
[1] http://www.census.gov/retail/
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